Rising real estate prices have made property development an increasingly attractive opportunity for owners of undeveloped “raw” land. Property owners involved in development, however, can face very different tax consequences—and different returns on their investments—depending on their status as an investor subject to capital gains tax rates or as a dealer subject to higher ordinary income tax rates.
Property owners can improve returns on development projects by structuring their transaction to divide their investor and dealer activities between separate entities. This allows them to bifurcate their income between capital gains taxed at 15-20 percent and ordinary income taxed at up to 37 percent. Property owners considering this option must take care to understand the specific factors involved in these transactions and take steps to adhere to their requirements.
Investor or Dealer
Treasury Regulation §1.1402(a)-(4)(a) defines a real estate dealer as “an individual who is engaged in the business of selling real estate to customers” for gain and profit. Under this definition, a real estate owner who engages in development activity would be considered a dealer and the gains would be subject to ordinary income rates. The regulation provides an exclusion that encompasses investors, noting that “an individual who merely holds real estate for investment or speculation and receives rentals therefrom is not considered a real-estate dealer.”
A key distinction between investors and dealers is how they hold the property—as a capital asset or as property held for sale to customers. IRC Section 1221 defines a “capital asset” simply as property held by the taxpayer (whether or not connected with his trade or business). This excludes property that is used in the “stock in trade of the taxpayer,” property that “would properly be included in the inventory of the taxpayer,” or property held “primarily for sale to customers in the ordinary course of his trade or business.”
Tax Treatment of Investors
A property owner’s treatment as an investor or as a dealer can be a critical factor in the success of a development project, as the tax treatment of real estate investors provides certain benefits that are unavailable to dealers. Most significantly, gains from the sale of property held as a capital asset for more than a year are taxed at the 15-20 percent capital gains rate under IRC 1231. Additionally, investors can defer income recognition through an installment sale under which gains from the sale are recognized in a tax year after the sale has occurred. They can also use an IRC Section 1031 like-kind exchange under which they can exchange investment property for another investment property in order to defer recognition of gains or losses that would otherwise be required at the time of a sale. Investors, however, are subject to a $3,000 capital loss limit and must treat selling expenses as reductions in sales proceeds. Notably, undeveloped land is not depreciable.
By contrast, gains from the sale of property by real estate dealers are taxed at the higher ordinary income rate of up to 37 percent and are subject to the self-employment tax of up to 14.13 percent. Dealers also cannot depreciate property held as inventory, use the installment sale method to defer recognition of the gain, or use a Section 1031 like-kind exchange to defer income recognition. Dealers can, however, deduct a range of real estate selling expenses as ordinary business expenses and can deduct ordinary losses without limitation.
